Valuation of Pharmaceutical and Biotechnology Companies: Comparable Multiples Method (Part 2)

In this article the Comparable Multiples Method (CMM) is discussed and analysed. CMM is based on a relatively basic principle; that the value of the target company (the company to be valued) can be derived through certain multiples (financial ratios) of similar (comparable) companies.

Step 1: Analysis of the Target Company

There are certain data that should be collected for the target. These are both financial and non-financial:

  • Non-Financial Data
    • Location: headquarters, countries of operation, location of subsidiaries.
    • Quoted Status: Publicly Listed or Private
    • Subsidiaries: number of subsidiaries, subsidiaries’ sector of operation.
    • Global Strategy: M&A, organic growth, future potential.
    • Product Pipeline: Number of products, breakdown of products’ type.
    • Number of competitors and potentially perform a SWOT and Porter’s 5 forces analysis as well as create a BCG matrix.
    • Market drivers and challenges.
  • Financial Data
    • Revenue structure: breakdown of revenues by area. For example, a company active in the Oil & Gas industry could segment its sales by type of product sold Natural Gas sales, Petroleum Sales, Bioethanol etc.
    • Cost structure: Where does the company spends its cash on compared to the industry? R&D, Marketing or Manufacturing?
    • Bench-marking of competitors and the target.

Step 2: Characteristics of Comparable Companies

The comparable companies should have similar Financial and Non-Financial Data (as in Step 1) with the target. At a later stage CMM will be applied on Sanofi, the meaning of “similar data” will be clearer and more specific.

Step 3: Collection of Financial Data and Multiples of Comparable Companies

There exist two different types of multiples. These are Enterprise Value multiples and Equity multiples.

  • Enterprise Value multiples: enterprise value (EV) is defined as Market Capitalisation + Net Debt (i.e. Debt – Cash). It is partially market-dependent (due to the market capitalisation component) but it has a significant enterprise specific element (net debt). The most commonly used EV multiples are EV/Sales, EV/EBIT, EV/EBITDA and EV/Free Cash Flow.
  • Equity multiples: these are multiples which are based on the market value of equity of the comparable company. PE ratio, P/Sales, P/Book Value and P/Operating Cash Flow are mostly used.

Step 4: Analysis

Before estimating the average and the median of the multiples above a careful consideration shall be given when ruling out outliers. Outliers are numerical values diverging from most of the sample. It should be noted that the median is estimated for ensuring that the sample is uniform (i.e. all outliers have been excluded, sample is converging). After analysing and deciding on the final multiples the market value of Equity and the Enterprise Value can be estimated based on the corresponding multiples and financial data of the target company (e.g. if  the average of P/Sales of the comparable companies has been estimated, then it should me multiplied by the sales of the target company to measure what its P is i.e. its market value of equity).

Example: CMM Valuation of Sanofi-Aventis (As of 31.12.2005)

In 2005, Sanofi-Aventis was particularly active in 3 main therapeutic areas: Cardiovascular (~10% of total sales), CNS (~20% of total sales), Blood (~15% of total sales) and Oncology (~10% of total sales). Using appropriate country filtering (U.S., Northern European and Japanese companies were included) and by searching through financials the following companies with similar revenue breakdown were identified:

 Baxter International
 Johnson & Johnson
 King Pharmaceuticals
 Mitsubishi Pharma
 Shire
 Torii Pharmaceutical

By assessing the characteristics of the sample one could observe a number of problems. Firstly, comparable companies in terms of market size are missing apart from Johnson & Johnson, which however, has a large medical devices segment and could be considered non-comparable. For the purpose of this valuation, Johnson & Johnson will be included. The second problem is the size of the sample. The sample contains 6 companies which is sufficient only if it contains highly comparable companies.

In the table below the multiples of the comparable companies are shown. Highlighted in red are the outliers which have been excluded in the calculation of the average and the median (click on the picture to see the actual numbers more clearly).

Comparables Companies - Average Multiples

Comparables Companies – Average Multiples

The table below presents the process of estimating the total market value of Sanofi Aventis’ equity based on the derived transaction multiples. Net Debt has only been subtracted from Enterprise Value to determine the market capitalisation of the company as figures derived from equity multiples are market values of equity.

Market Value of Equity Estimation - CMM Approach

Market Value of Equity Estimation – CMM Approach

Using the CMM approach the market value of equity of Sanofi-Aventis as of 31.12.2005 was estimated at € 92,954 mn. The market capitalisation of Sanofi-Aventis was € 103,656 mn. (31.12.2005).

Summary

In CMM one collects a sample of comparable companies based on both financial and non-financial criteria. Equity and enterprise multiples are collected for the comparable companies and the average and median are calculated for the comparable companies and outliers are excluded. Thereafter, the average multiples are applied to the target company. Net debt has to be subtracted from the enterprise value derived from the comparable multiples, as equity multiples estimate the market value of equity and the aim is to compare these values to the actual market capitalisation of the target company.

Although a 10% deviation between the derived value and the actual market capitalisation of Sanofi-Aventis can be considered as huge when considering share price performance, CMM is highly sensitive to the selection of the sample and the average multiples. A difference in a decimal point in a high-weight multiple can have a large impact on the final value of the company.

The next article will focus on the Comparable Transactions (CT) methodology and provide an overall summary of the valuation results from the 3 methodologies (CMM, CT and DCF) on Sanofi.

Valuation of Pharmaceutical and Biotechnology Companies: DCF (Part 1)

As most Finance professionals say valuation is more like an Art rather than Science. There are various valuation methodologies that one could apply in order to determine the value of a company. The main methods are: Discounted Cash Flow (DCF), Comparable Multiples Method (CMM), Comparable Transactions (CT) and Real Options (less common).

DCF incorporates the future cash flows of the company, its discount rate  (WACC – weighted average capital cost) and the time period of the projections. As an example the valuation of Sanofi-Aventis will be peformed as of 31.12.2005.

Step 1: Determination of Free Cash Flow

Free cash flow represents the cash flow available for distribution. The following formula is usually applied for the calculation of free cash flow (to the firm):

FCFF Formula

Free Cash Flow to the Firm – Estimation

Where:

EBIT = Earnings Before Interest and Taxes

  • Defined as: Sales – Cost of Goods Sold (COGS) – Operating Expenses – Depreciation, Amortisation

T = Effective Tax rate

  • Country Specific. A special care should be given on the country’s tax law. For example, in some countries, tax losses can be carried forward and therefore the effective tax rate will differ from the common flat rate.

d(NWC) = Change in Net Working Capital

  • Defined as (Current Assets – Current Liabilities) at current period  less (Current Assets – Current Liabilities) at previous period

CAPEX = Capital Expenditure

  • Defined as (Property, Plant and Equipment + Intangible Assets) at current period  less (Property, Plant and Equipment + Intangible Assets) at previous period.

D&A = Depreciation & Amortization

The next step in order to determine the value of the company is the calculation of WACC.

FCF in complex situations, where balance sheet items cannot be easily determined (e.g. in the case of multinational companies), can be also calculated as:

Free Cash Flow Alternative Calculation

Free Cash Flow to the Firm – Alternative Formula

This formula shall also exclude restructuring costs and non-recurring items.

Step 2: Determination of WACC

WACC takes into account the capital structure of the company (i.e. amount of equity and debt) as well as the risk of equity and risk of debt.

WACC Formula

WACC Formula

Where:

E = Value of Equity

  • E can be determined by taking the 3-month average market capitalisation of the company or market capitalisation as of the reference date

D = Value of Debt

  • D can be found in the financial statements of the company

V = E + D

  • Sum of E and D

Re = Cost of Equity

  • Re can be estimated using the Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model (CAPM)Z

Capital Asset Pricing Model (CAPM)

    • Where Rf is the risk-free rate which can be estimated from the yield of long-term bonds of the in which the company operates (e.g. U.S. 10-year bond yield ~3%).
    • Where β represents the volatility of the company’s stock price in the capital markets (can be found in financial statements or real-time stock information providers). Often referred as levered beta.
    • Rm – Rf is the equity risk premium (long-term return from the financial markets excess risk-free rate). Damodaran provides updated values of equity risk premiums.

Rd = Cost of Debt

For publicly traded companies WACC depends on the capital structure of the company. Cost of debt is in most cases less than the cost of equity because cost of debt is tax deductible. According to the Modigliani–Miller theorem if a company reaches the point of financial distress, cost of debt has a negative effect in the optimal capital structure of the company. As a result WACC increases and the value of the company is reduced.

Step 3: DCF Calculation

Discounted cash flow method uses projected cash flow to determine the current value of the firm. The formal formula for DCF is:

Enterprise Value Calculation - DCF Formula

Enterprise Value Calculation – DCF Formula

Where:

TV = Terminal Value

i = the specified year

n = the number of years

The second part of the equation is called Terminal Value. This is done to compensate for uncertain future returns (i.e. future cash flows cannot be estimated up to infinity).  There exist various models for terminal value. The most common model is the stable growth model, as shown in the formula above. This model assumes that the company will grow with a specific growth rate defined as g. It has been suggested that this growth should have two main features: a) It should represent the company’s growth at maturity in its life cycle, b) it should be less than the world’s or country’s GDP growth rate (otherwise the company would be “larger” than the world at infinity). Damodaran has provided a more in-depth analysis of the different types of terminal values.

Example: DCF valuation of Sanofi-Aventis as of 31.12.2005

In this example the value of Sanofi-Aventis will be estimated as of 31.12.2005 and will be compared to the market capitalisation of the company at the same period. This is done because it is highly difficult to perform a current DCF, since there are various parameters that cannot be accurately determined (e.g. future sales, future investments, restructurings etc.). However, an interesting conclusion that can be drawn from this analysis is whether the market was overvaluing or undervaluing the shares of the company at that time. In addition, if this methodology is performed in a large sample of pharmaceutical companies a historical overview of how the market valued the stock of pharmaceutical firms in the past can be obtained.

Based on published and audited consolidated financial data of Sanofi during the period 2005 – 2010 (see Sanofi Annual Reports) and author’s analysis the following results were obtained:

Enterprise Value Estimation - Discounted Cash Flow Approach

Enterprise Value Estimation – Discounted Cash Flow Approach

A growth to perpetuity of 3% was assumed. In addition, it has been assumed that CAPEX will be equal to D&A in perpetuity (therefore free cash flow formula used in terminal value will be lower than previous years if in previous years D&A was higher than CAPEX). This is because at perpetuity growth CAPEX shifts to replacement CAPEX, meaning that the Company tries to offset the effect D&A rather than introducing new capital investments. In addition, at Terminal Value FCFF was actually calculated rather than assuming last years FCFF and applying the growth to perpetuity in order to apply the previous adjustment (D&A = CAPEX).

The market value of equity using DCF was estimated at € 91,925 mn. based on the analysis above. The market capitalisation of Sanofi-Aventis as of 31.12.2005 was € 103,656 mn.

 

Conclusion

There exist two potential explanations for the variation between intrinsic (DCF) value and the actual market capitalisation of Sanofi. Firstly, the market does not have the information that already exists (as this is a historical valuation). For example, an acquisition would increase CAPEX (which reduces FCFF in the short term) but in the longer term it would cause EBIT to rise and potentially result in a share price increase. However, the reason the 2005 – 2010 period was selected is that it is after the merger between Sanofi and Aventis in early 2004 and before the Sanofi – Genzyme acquisition, to avoid any distortions caused by the latter transaction. Secondly, historical DCF valuation uses a specific time range (of up to 5 years + terminal value for mature companies, while 8-10 years + terminal value for start-ups) based on actual FCFF values while the share price is based on investors’ expectations which are occasionallyshort-term. Moreover, small changes in WACC and growth to perpetuity can have a major effect on the overall market value of equity estimation. Finally, considering the sensitivity of the model on such effects, it can be said that overall, the intrinsic value of Sanofi agrees with that of the market. This means that investor’s expectations were realistic at that time as they were aligned with the actual performance of Sanofi-Aventis.

Within the next week the Valuation of Pharmaceutical and Biotechnology Companies: Comparable Multiples Method (Part 2) will be published which will be compared with the results of the DCF approach.